A key driver of the economy is disposable income since domestic demand is the biggest component of almost all economies; in the UK, domestic demand accounts for roughly 60% of GDP. When the rate of inflation runs above the rate of wage increases, disposable income falls and consumers may need to “tighten their belts”, reining in discretionary spending.
In the UK, the official measure of inflation has been higher than the average increases in wages since February 2017. According to the Office for National Statistics (ONS), wages increases are now above inflation for the first time since then, but only if you use their new measure of inflation which includes an element for housing costs (CPIH). Under the new measure, wages outstripped inflation by 0.2% for the three-month period to the end of February 2018, compared to the same period in 2017. However, if the traditional measure of inflation, the consumer price index (CPI) is used, then inflation is running above wages at 2.9% vs 2.8%. Many anecdotal stories in the UK suggest that inflation is considerably higher than the official figure for certain items.
Unemployment in the UK stands at 4.2% - a level that many economists would suggest is full employment. However, it is still the case that many (employed) people are on “zero hours” contracts which means that they only get called into work when needed; others are working fewer hours than they would like in part-time work. The unemployment figures do not discriminate between these groups of workers and their colleagues working on fixed, full-time posts. These factors may explain, partially at least, whilst wage growth is not stronger since a smaller pool of potential employees should mean that employers have to offer better terms and conditions to attract the staff that they need. So far, economic evidence suggests that this is not the case in the UK, nor the USA for that matter.
The inflation figure is still above the Bank of England’s target level of 2%. The narrowing of the wage/inflation gap will make a rate hike next month more likely, but the UK’s lack-lustre growth mitigates against tightening monetary policy right now. It will be interesting to see which way the MPC jumps and the reasoning behind their decision.